Strategy: Set up a self-insured medical reimbursement plan—also called a Section 105 plan—for your business. This kind of plan reimburses specified medical expenses to your employees—and to you—from the business’s coffers.
Assuming that the plan is in writing and meets other technical requirements, it’s a win/win situation. As the employer, you can deduct the reimbursements, including those to cover employees’ out-of-pocket medical costs. And eligible employees generally aren’t taxed on this perfectly legal .
Sound too good to be true? The IRS approved this medical reimbursement setup years ago. (IRS Revenue Ruling 1971-588) But you must toe the line to avoid any tax trouble.
Here’s the whole story: Typically, a Section 105 plan reimburses employees for uninsured health or accident expenses they or their dependents incur. (The plan document should define eligible costs to include medical and dental insurance premiums, insurance deductibles, co-payments, prescriptions and other eligible expenses such as vision care.)
So long as you stay within the tax law boundaries, you can customize the plan to meet your needs. For instance, you generally should establish annual reimbursement maximums for each employee. You may also want to limit eligibility to full-timers.
What have you accomplished from a tax perspective? Plenty. Here’s a quick look:
-You can generally deduct all the medical expense reimbursements paid to employees as business expenses.
-If you’re self-employed, you grab an extra tax break because the write-off also reduces your self-employment tax.
-Employees receive the payments 100 percent tax-free as a fringe benefit. This arrangement works especially well for a sole proprietor or the owner of a single-member LLC who employs a spouse.
But the plan can’t discriminate in favor of highly compensated employees, including yourself (e.g., a more than 10 percent shareholder) or other key employees. If it does, the medical reimbursements are taxable to the highly compensated employee.
Tip: In any event, paid to you or another 2 percent-or-more shareholder of an S corp are taxable. But other tax perks for a Section 105 plan may be worth it to S corp owners.
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